Ambiguity and Time-Varying Risk Aversion in Sovereign Debt Markets
58 Pages Posted: 25 Jul 2016 Last revised: 13 Aug 2016
Date Written: August 1, 2016
This paper introduces changes in the level of ambiguity as a complementary source of time-varying risk aversion. We show in a consumption-based asset pricing model with simultaneously risky and ambiguous assets that a rise in the level of ambiguity raises investors' risk aversion. The effect is quantified in an application to European sovereign debt markets using a structural VAR to achieve identification in the data. We proxy for ambiguity using a measure of macroeconomic uncertainty and decompose empirically credit default swaps (CDS) for Spain and Italy into three shocks: fundamental default risk, risk aversion, and uncertainty. We find that shocks to uncertainty significantly increase international investors' risk aversion, accounting for about one fifth of its variation at a five week horizon, and have a significant and economically relevant impact on sovereign financing premia.
Keywords: Time-varying risk aversion, Ambiguity, Uncertainty, Sovereign debt, Identification via heteroscedasticity, Maxmin
JEL Classification: C32, D80, E43, G01, H63
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